The Dodd-Frank Act's Curious Bequest: the Living Will

To avoid a Lehman Bros. redux, the Dodd-Frank Act orders federal regulators to prepare for the next crisis by obtaining blueprints for unwinding the largest financial companies.

The creators of these designs will be the giants themselves, and if that sounds too good to be true, it is.

Even the government's guru on the topic concedes the road ahead is daunting.

"It is going to be really hard, but think about it this way: what's the alternative? The alternative is not to throw up your hands and say we can't do this," said Michael H. Krimminger, deputy to the Federal Deposit Insurance Corp. chairman for policy. "We do not want to end up in the situation that we were in the fall of 2008, when critical information was not available."

No one disagrees with that, but plenty of people question whether the living will is the answer. They claim the plans won't work and even if they did, the costs would far outweigh the benefits.

"It would be better to call it 'My best guess of what I would do if I had to wind my company down.' This is really a bit of Alice in Wonderland," said V. Gerard "Jerry" Comizio, a partner at Paul Hastings. "It will either be expensive or useless, and either way it will not be useful."

Robert L. Clarke, the comptroller of the currency who regulated through the banking crisis of the early 1990s, goes a step further, calling living wills nothing more than a fig leaf for "too big to fail."

"The whole thing is premised on the fact that people don't like 'too big to fail,' " said Clarke, now a senior partner at Bracewell & Giuliani in Houston. "They say we are not ever, ever, again going to step in and save a big bank. Of course they are. I sure hope they are, because we are going to be in a heck of a mess if they don't.

"I don't like it any more than anyone else, but you have to do it and there is no playbook. You have to make it up as you go along."

Living wills will be written by financial companies with at least $50 billion in assets and must be approved by both the FDIC and the Federal Reserve Board. That one sentence alone poses a host of problems.

Companies are in business to stay in business, and it's a huge conflict of interest to ask them to come up with their own resolution plans. Besides, would you trust a plan drawn up by executives who drove their company into a ditch?

And on the regulatory side, getting approval by two agencies is just asking for delay and confusion. There are great people working at both these agencies, but the rivalry between the FDIC and the Fed is intense, and asking them to work together on this is like asking Nancy Pelosi to work with Sarah Palin on a budget fix.

Let's assume the company did write a great plan and the regulators, in a moment of cooperative bliss, signed off on it. How long would it be relevant and how would it be kept up to date?

And how will even the best, most timely plans anticipate the next crisis, the next set of circumstances that would cause these plans to be used? By the way, it's unclear how confidential all this information on how best to chop up and sell off companies will be.

Dodd-Frank gives the FDIC and the Fed 18 months to write a joint rule governing the drafting of these living wills.

"I think it's absolutely critical that we do it faster than that," Krimminger said, predicting final rules would be out by July 2011. "We want to make sure this process is well on its way as soon as possible."

In fact, Krimminger said regulators are already working with banks.

"This discussion has been going on pretty intently since 2008, so it's not something that suddenly shot out of the blue and we have to wait for the regs," he said.

So what's required? According to a thorough analysis of the new law by Davis Polk, living wills must explain how any insured depository institution is protected from risks posed by nonbank subsidiaries of the company. They must include complete descriptions of the company's ownership structure, assets, liabilities and contractual obligations. They must identify both cross-guarantees tied to different securities and major counterparties, and explain how to determine to whom collateral of the company is pledged.

And just in case that's not enough, the law allows the government to collect any other information that the Fed and the FDIC jointly require by rule or order.

If the FDIC or the Fed does not like a company's living will the agencies can require more capital and liquidity or restrict its growth, activities or operations.

A company will have two years to resubmit a better plan, and if that one doesn't pass muster, then the FDIC and the Fed can start requiring the company to sell assets.

OK, there has to be something good about living wills, right?

The experts I interviewed all agreed that companies that go through the process of writing a living will are likely to find inefficiencies and redundancies and come out on the other side with a simpler, more rationale structure.

"The process of having thought through how these things relate to each other will end up creating some structural, organizational changes at some of the big firms," according to Krimminger. "I think it's actually going to improve the efficiency of operations of the firms."

Others agree living wills will make large companies simpler, and that's not a bad thing. But is the cost of all this worth a little simplicity?

For Krimminger, the answer is easy. "If I look at the cost of the fall of 2008, absolutely."